Wednesday, July 30, 2008

Robert Biggs of the Beacon blog recently posed this question: Perhaps someone can enlighten me. I simply don’t understand how we can have a “credit crunch” without substantial increases in real interest rates across the board.

He enumerated the following data in the same post: For months, the news media have been dispensing reports of a “credit crunch.” I have been puzzled by these reports because scarcely a day passes that I do not receive offers in the mail or via the Internet from lenders who want to lend me money to refinance my mortgage or to make purchases with a credit card they stand ready to issue me.

Having my doubts, I checked some standard interest-rate data conveniently available online at the St. Louis Fed site. ….The first series I checked pertains to the bank prime lending rate. During the latter half of the 1990s, this interest rate varied from 7.75 percent to 9.0 percent. It hit 9.5 percent in May 2000, then began a long decline, gradually reaching a low of 4.0 percent in June 2003. Afterward it climbed slowly to a high of 8.25 percent in June 2006. For the past two years it has fallen again, reaching 5.0 percent in April 2008. Given that the rate of change in the producer price index has been substantially greater than 5 percent during the past year, borrowing money at 5 percent seems to me to indicate, not a credit crunch, but a credit bonanza. A business borrows, finances inventory, holds it for a year, and earns a 5-10 percent rate of return. What could be simpler and more delightful?

But, you protest, the credit crunch is really in the housing industry. Well, let’s have a look at mortgage rates for 30-year conventional mortgages. Although rates have risen in the past few months, they still compare favorably with rates that prevailed in 2006 and 2007, and they are not more than about 1 percent higher than rates that prevailed during the housing boom in the first half of this decade. Given that the rate of inflation is greater now, present real rates may be lower than they were during those halcyon days. If a credit crunch exists, it is certainly not showing up in the mortgage-lending markets. Are we to believe that lenders are simply refusing to lend, rather than lending at higher rates to reflect a diminished supply of loanable funds?

If credit were being crunched, one supposes that lenders would be willing to pay higher rates for funds placed at their disposal. Yet six-month certificates of deposit are now yielding less than the rate of inflation—people are paying the banks to take their money!

…..Of course, lenders have begun during the past six to twelve months to awaken to the fact that for four or five years, owing to the Fed’s expansionary policies in rapidly increasing the money stock at that time, they had been making loans to nearly every sentient being who asked for one, often without the performance of due diligence and without insisting on an interest rate that reflected the true riskiness of the borrower’s repayment.

Banks and other financial institutions continue to lend, even for mortgages, to well-qualified borrowers. In any event, the real-estate-linked lending markets are only a relatively small part of the overall market for loanable funds.

True. In answer to his original question, it might be well to go back to the proverbial “the bank gives an umbrella to those who don’t need it and takes it away from those who need it”. There is a credit crunch now among sub-prime borrowers. But if you happen to be among those deemed credit-worthy, banks will still beat a path to your door. Banks have been feeling the pain of write-offs from lending to sub-prime borrowers, that there is nothing they need more now than an infusion of good accounts to get their portfolio looking healthy again. Because there is still competition from many banks, and too few good credit clients who still feel comfortable taking out more loans, the rate for these prime clients will remain attractive, and probably become even more so.

The credit crunch refers more to the banks, rather than to any inability by creditworthy companies and individuals to borrow money. And if depositors are quite willing to park their money at sub-inflation rates (this is money that can be withdrawn on demand), that only means there is a dearth of investment alternatives. That doesn’t take away from the fact that banks have already lent money that can no longer be repaid, leading to their credit crunch. Which leads us to the reason the Fed is coming in as lender of last resort.

In a related post, Biggs rants against the Fed bailout plan: Yes, what is a government for, if not to save us from the impending disaster that its own policies have produced? Thank heavens for the government!

Noting that in the bailout of Fannie and Freddie, the Fed commits to lend them at 2.25 percent for any borrowed funds: …..lending at 2.25 percent when the rate of inflation is at least twice that great means that the lender is giving away money. The real interest rate on such a loan is negative.

Worse, because the Fed itself is the lender, the loan will take the form of newly created money—that is, the loan will be pure inflation, a hidden tax on all assets denominated in dollar units, including dollar balances themselves.

True, this could be a case of where the cure could end up spreading the disease. The Fed bailout could end up saving the GSEs but destroying purchasing power for everybody else in the US economy.

Bernanke is in an unenviable position. He arrived at the Fed just when the US financial system is about to be checkmated. If he tightens money, the toxic effects of the sub-prime mess intensifies. If he loosens money, the value of the currency goes down the toilet.

Now if the US currency is expected to go down the toilet, Americans will have an incentive to send whatever money they still have abroad, and those who earn them abroad will have an incentive to keep them abroad. And this will lead to the next bubble, which could be in whatever will hedge the American slowdown – like the Emerging Markets.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.